You walk into work one morning, fill up your coffee cup, turn on your computer, and click over to your favorite news site. In an instant, you see there’s rioting in the streets of Istanbul. Argentina’s currency is in a freefall. The Federal Reserve has hiked interest rates unexpectedly, while the largest land trust in China is on the brink of default. You gasp for a breath and fall back into your chair, spilling coffee all over the tie your daughter gave you for Christmas. You start to think that this is going to be a very bumpy ride. Historically, in similar low-rate, macro-volatile environments, you may have turned to asset classes like high yield, emerging markets, and preferred securities to add yield to your portfolio. But by doing so, you are exposing yourself to asset classes that are more sensitive to heightened systemic risks with little room to hide. So, what if there was an option that offered a similar yield/return profile and also had the ability to defend against increased macro headwinds.

Imagine…

…a strategy that provides a more integrated and sophisticated approach to adding yield and return, while managing downside risk.

…your ‘yield-enhanced’ investment allocations have the ability to quickly and dynamically adjust, while helping to provide downside protection.

…your allocations to different risk assets were directly linked to a forward-looking assessment of the macroeconomic and risk environments, with the potential to greatly reduce risk when the horizon turns stormy.

AND…you could do ALL of this by only investing in high-quality, investment grade-rated companies that have undergone a fundamental, long-term transformation of their business – a mandated conversion, overseen by global regulators, that has reduced business risk and increased capital ratios to historic levels.

Such opportunities do exist…within strategies that are able to invest across the entire capital structure of high-grade companies. These strategies dynamically allocate risk along all parts of a firm’s capital structure in order to help maximize return/yield opportunities in good times and help protect investments during bad times, compared to strategies that dynamically allocate to a single high-yielding asset class whose issuers are highly correlated during times of stress. The net result is a portfolio made primarily of financial companies that, in the aggregate, can perform in up- and down-markets. They provide this opportunity while realizing better risk/reward profiles and more robust downside risk protection than would be available by only allocating to one part of the capital structure, such as preferred securities.

However, successful execution of an investment strategy dedicated to opportunities across the capital structure must have certain ingredients:

A dynamic, integrated approach is a must

The current global environment, with increasingly interconnected systemic risks, demands the skill to dynamically change asset allocation. Correlations quickly rise and the global trading environment moves too rapidly to try and manage macro shocks without dynamic asset allocation. This includes not only proactive asset allocation, but also active hedging to help protect the downside when systemic risk increases significantly.

One of the many lessons from the global financial crisis is that investors, in their search for yield, felt forced to invest in companies, countries, or structures in which they weren’t really comfortable. Given investors’ current demand for yield, a better alternative is to remain exposed to high quality, global companies but adjust portfolio risk as the macro-risk environment dictates by investing in different parts of a company’s capital structure. This necessitates the skill to evaluate the relative value, for example, of a global bank’s lower-Tier-2 debt trading at 1.8x its senior spread versus its lower-rated contingent convertible (CoCo) debt trading at 4.2x its senior spread. Exploiting capital structure inefficiencies is vital.

Dedicated expertise of companies & securities

Clearly, all companies and all securities are not equal. Independent credit assessments are now more valuable than ever as the efficacy of rating agencies have continuously proven to be lacking. In addition, expertise is required to opportunistically take advantage of all parts of a firm’s capital structure and understand their relative value, unique risks, and nuances.

This analysis provides the foundation for the dynamic asset allocation mentioned above, placing targeted risks in all parts of the capital structure. When macro risk is high, this allows for quick de-risking by allocating to covered bonds (debt issued by banks and secured by primary claims on mortgages on the bank’s balance sheet) and senior bonds. Conversely, when macro risks are subdued, the portfolio can quickly allocate to higher-yielding portions of a company’s capital structure such as subordinated debt, Tier-1 issues, and contingent convertible securities.

So with a risk-managed capital structure strategy backing you up, you can pour your next cup of coffee, relax comfortably in your chair, straighten your tie, and feel calm about the plan you’ve outlined to navigate this era of heightened volatility. With the right strategy, approach, and expertise, there are ways to defend against macro shocks in the current environment. Allocating across the capital structure of investment grade-rated companies has potential to offer a better risk/reward payoff than investing in individual higher yielding, high-risk asset classes.

The information in this article has been derived from sources believed to be accurate. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

The information in this article contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.

Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions in this article. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security.

Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.

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